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Level III Estate Planning in a Global Context Summary Estate Planning, Wills, and Probate Estate planning: Planning the transfer of one’s estate during one’s lifetime and at one’s death Objectives of estate planning:  To minimizing cost of transferring property to heirs  To transfer estate assets to the desired beneficiaries  To plan for efficient use of estate assets Estate Financial assets Tangible personal assets Immoveable property Intellectual property Will (testament): Legal document containing instructions for the distribution of one’s property after death Testator: A person transferring assets through a will Testate/intestate: A person who dies with (without) a will is said to have died testate (intestate) Probate: Legal process to confirm the validity of a will Advantages of Probate Disadvantages of Probate Ensures disposition of assets to heirs according will and in orderly manner Relatively costly and time consuming process Protects creditors by ensuring payments of debt Compromises privacy of decedent and heirs www.ift.world Tools to avoid probate process: i Joint ownership ii Partnerships iii Living trusts iv Retirement plans v Life insurance Wealth Transfer Taxes; Effects of Legal System, Forced Heirship, Marital Property Regime Legal systems: Common law system: uses inductive reasoning and it draws rules from specific cases Civil law system: uses deductive reasoning and rules or concepts are applied to particular cases Regimes: Example 1: When a country has both community property and forced heirship a) Forced heirship: children have right to fixed share of parent’s estate regimes, surviving spouse has a right to b) Community property: each spouse has indivisible one-half interest in receive the greater of his/her share income earned during marriage On death half property goes to under community property or forced spouse Other half divided according to will heirship rules c) Separate property: each spouse owns and controls property as an individual Example 2: Paul leaves an estate worth 600,000 for his children Inheritance tax is 40% of amount above a Two principal forms of wealth transfer: threshold of 312,000 Inheritance tax is 40% of (600,000 Gifts: lifetime gratuitous transfers or inter vivos transfers – 312,000) = 288,000 Bequests: testamentary gratuitous transfers Example 3: Progressive estate tax Chao leaves million for his children First 600K taxed at 2%, next 900K taxed at 4%, remaining 500K taxed at 7% www.ift.world Core Capital and Excess Capital Core capital: minimum amount of capital required to maintain lifestyle and fund essential and emergency needs Excess capital: capital in excess of core capital Two ways of estimating core capital: 1) mortality tables and 2) Monte Carlo analysis Mortality tables use the risk-free rate to discount spending needs Core capital is estimated using the formula: Core capital = 𝑵 𝐩 𝐒𝐮𝐫𝐯𝐢𝐯𝐚𝐥 ×𝐒𝐩𝐞𝐧𝐝𝐢𝐧𝐠 𝐣 𝒋=𝟏 𝟏+𝐫 𝐣 Ruin probabilities for a balanced portfolio Monte Carlo analysis forecasts spending needs and then estimate size of portfolio needed to meet forecasted spending needs – Forecasts based on statistical properties of underlying asset returns – Captures capital market risks much better than mortality table approach www.ift.world Retirement Age Spending per $100 Life $2 $3 Expectancy 50 78.1 1.8 6.4 55 83.0 1.8 6.3 60 83.4 1.5 5.2 65 83.9 1.1 4.0 Relative After-Tax Value of Lifetime Gifts and Testamentary Bequests The choice between a lifetime gift and a testamentary bequest depends on the future value under each option This is captured using relative value If the relative value is > 1, make a lifetime gift These formulas assume that tax is paid by recipient If the tax is paid by the donor: Gifting is better even when gift tax rate = estate tax rate and returns are taxed at the same rate because gift tax paid by the donor reduces the size of donor’s taxable estate, resulting in decrease in donor’s estate tax www.ift.world After-tax benefits of basic estate planning strategies  Generation skipping: Transferring capital in excess for both the first and second generations directly to the third generation Relative value of generation skipping = (1 − tax rate of capital transferred from 1st to 2nd generation)  Spousal exemptions: Tax-free transfer of assets (either as a gift or a bequest) to spouse  Valuation discounts: Transferring assets that are subject to valuation discounts reduce the basis of transfer tax  Deemed dispositions: Bequests/transfer is treated as if the property were sold  tax is levied only on the value of unrecognized gains rather than on the total principal value  Charitable gratuitous transfers to charitable organizations offer the following advantages: a) Donations are not subject to gift transfer tax b) No taxes on investment returns c) Donations are income tax deductible www.ift.world Estate Planning Tools Common estate planning tools: 1) trusts, 2) foundations, 3) life insurance, 4) companies Trust: Legal arrangement in which a settlor (or grantor) transfers assets into the care of a trustee, who manages these assets on behalf of a beneficiary Trust can be revocable or non-revocable Revocable Trust Irrevocable Trust Yes No Grantor Trustee No Yes Grantor can rescind/revoke the arrangement Tax and other liabilities responsibility Assets are protected from creditors’ claims against a settlor Fixed Trust: distributions are made to beneficiaries according to the specific terms established by the grantor Discretionary Trust: trustee has the discretion to determine the amount and timing of distributions www.ift.world Objectives of a trust: • Control over assets • Asset protection • Tax reduction • Avoidance of probate process Estate Planning Tools Foundation • Legal entity, set up to hold assets for a particular purpose • Like trusts, foundations survive the settlor Life Insurance • Policy holder transfers assets (premium) to insurer • Insurer has obligation to pay death benefit to beneficiary Benefits: 1) Lower taxes 2) Avoid probate 3) Protection from creditors Forced heirship can be avoided by: a) moving assets into an offshore trust governed by a different jurisdiction; b) gifting or donating assets to others during their lifetime; c) purchasing life insurance; Controlled foreign corporation (CFC): a company in which the taxpayer has a controlling interest (as per home country law) but the company is located outside a taxpayer’s home country Transferring assets to a CFC helps to defer taxes on earnings of the company until the earnings are actually distributed to shareholders or the company is sold www.ift.world Tax Jurisdiction Source jurisdiction (territorial tax system) Residence jurisdiction Income tax Tax income sourced (generated) within country’s borders Tax based on residency (regardless of whether income is generated within or outside its borders) Gifts and bequests Tax only domestic wealth transfer Tax all wealth transfer (domestic and foreign) Exit Taxation: Taxes charged on unrealized gains accrued on assets that are removed from taxing jurisdiction Double Taxation: When two jurisdictions seek to tax the same income or assets Three forms of tax conflicts in double taxation: 1) Residence-residence conflict: Two countries claim residence of the same individual 2) Source-source conflict: Two countries claim source jurisdiction of the same asset 3) Residence-source conflict: One country claim residence jurisdiction on individual’s worldwide income whereas other country claim source jurisdiction Income earned on investments are located in country A but are managed from country B A person is a resident of country B but has investment property in country A www.ift.world Double Taxation Relief Methods used to provide double taxation relief Example: Tax imposed by a residence country on worldwide income is 40%; tax imposed by foreign government on foreign-sourced income is 30% Tax liability Max [40%, 30%]  Tax-payer will pay 40% Credit method Exemption method Max [TResidence, TSource] Out of 40% • 30% will be paid to foreign-government • 10% will be paid to domestic government TSource 30% collected by foreign government 0.40 + 0.30 – (0.40 × 0.30) = 58% Deduction method TResidence + TSource (TResidence ì TSource) Out of 58% 30% will be paid to foreign-government • 28% [i.e 0.40 – (0.40 × 0.30)] will be paid to residence or domestic country Double taxation treaties may help resolve residence-source and residence-residence conflicts but not source-source conflict www.ift.world 10 Impact of increasing international transparency and information exchange among tax authorities on international estate planning  With an increase in information exchange and transparency across countries, it is becoming difficult to locate undeclared funds in offshore savings accounts and other offshore structures to avoid detection by home country tax authorities  The key to providing estate planning advice is to use compliant, tailored, tax-efficient strategies – Tax avoidance: a legal method used to minimize taxes using legal loopholes in the tax codes – Offshore banking centers Tax evasion is avoiding or minimizing taxes through illegal means e.g misreporting or hiding relevant information from tax authorities www.ift.world 11 .. .Estate Planning, Wills, and Probate Estate planning: Planning the transfer of one’s estate during one’s lifetime and at one’s death Objectives of estate planning:  To minimizing cost of transferring... donor’s taxable estate, resulting in decrease in donor’s estate tax www.ift.world After-tax benefits of basic estate planning strategies  Generation skipping: Transferring capital in excess... information exchange among tax authorities on international estate planning  With an increase in information exchange and transparency across countries, it is becoming difficult to locate undeclared